UBS in Moscow -

After years of consistently strong performance, the Russian market has lost its appeal to portfolio investors and, clearly, the market looks cheap on multiples based on our current oil price of $120 per barrel in 2009. According to our analysis, the market is currently pricing in an oil price of $50 per barrel for 2009.

The Russian stock market has declined 53.8% in the year to date and, significantly, underperformed the other BRIC markets and the MSCI Emerging Markets. Russia has underperformed Brazil by 50%, China by 14%, India by 29% and the MSCI Emerging Market index by 22%.

We believe the fall was mainly caused by investor concerns about global and, in particular, emerging market economic growth, as well as the implications for commodity prices. But at least some of the underperformance has to be attributed to domestic factors. Over the last few days, concerns about the robustness of Russia's financial infrastructure have become an issue, which culminated in the closing of Micex after a sharp deterioration in trust between market players caused liquidity to be seriously impaired.

On the positive, this immediately sparked a consultation process between the Central Bank of Russia (CBR), Micex and local and foreign brokers to resolve the issues. We believe that a solution will involve the provision of liquidity by the CBR to broker dealers. This is what the Federal Reserve did and we think the CBR will follow suit. This should result in the orderly restart of trading in Micex. However, given that the level of leverage will necessarily be much lower and the fact that concerns about counterparty risk will not immediately disappear, liquidity is unlikely to reach previous levels in the short run.

We expect that the technical factors like forced selling and concerns about liquidity in the market will diminish eventually and the focus will be once more on fundamentals. On that front, we believe the biggest risk is the deteriorating global environment.

Slowing growth

Economic growth, particularly in the emerging market space, is expected to slow more than initially thought. This has caused an unwinding of long commodity positions, which coupled with renewed concerns about contracting demand, resulted in a plunge in commodity prices. Until concerns about contracting commodity prices and forced selling subside, we believe the performance of the Russian market will be sentiment driven and valuations and fundamentals will not be a crucial element in the investment decision-making process.

In this note, we have attempted to stress test our financial and valuation models to answer the question of what economic scenario current market valuations are pricing in. We do not really believe that valuations in themselves will be a sufficient trigger for the negative market trends to reverse, however, we still believe this analysis will be useful once investors get comfortable with broader global risks and try to reassess investing in Russia on a fundamental basis.

We have prepared four macroeconomic scenarios based on different oil price forecasts in 2009, attempting to understand the resilience of Russia's economy, company forecasts and valuation and investment implications. Our four scenarios assume Brent averages: $120 per barrel (our current house forecast), $100, $80 and $60. Our assumptions are summarized in the table below.

The exercise shows that if the oil price averages $100 and even $80 per barrel, the impact on the financial performance of domestic companies will be relatively limited. At a $60 oil price, the impact is more meaningful. On average, our analysts expect earnings of companies oriented to the domestic market to fall 15% relative to our base-case scenario. In the commodity space, we expect an earnings contraction of 35%-69%.

We believe the market is pricing in an oil price of approximately $50 per barrel. More specifically, the results show that at $60 per barrel in 2009, the equity risk premium in the Russian market would be 8.4%, even after adjusting earnings to that scenario. Thus given that we assume a fair equity risk premium of 7.5% for Russia, the market effectively is now pricing in an oil price of below $60 per barrel, we believe.

Given our analysis, we believe the market is oversold and may rebound once concerns about the domestic financial infrastructure are resolved. However, we believe that for the RTS to return to sustainable growth and rise above 1400, investors would want to see commodity prices somehow stabilising and concerns about global financial institutions disappearing.

In our view, the oil and gas companies are better places to be once the market recovers given valuations and potential changes in taxation. Among domestic industries, we favour wireless telecommunications and select power utilities. Banks are fundamentally attractive.

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